UK: Enterprise Management Incentives

Last Updated: 20 February 2001
Article by Graeme Nuttall

In Brief

Enterprise Management Incentives (EMI) Gain In Popularity
What Is An EMI Option?
Using EMI Options
The EMI Framework
Are The Qualifying Conditions A Problem?
Eligible Employees
Are The Tax Advantages Worthwhile?
The Rival Company Share Option Plan
How FFW Can Help
Who Are We?

Enterprise Management Incentives (EMI) Given Extra Boost

This briefing paper supersedes the version dated February 2001. The enterprise management incentives (EMI) provisions, introduced in the Finance Act 2000, created a new tax advantaged share option for employees which is proving very popular. As of March 2001, over 1,000 companies had granted EMI options. Changes made in the Finance Act (enacted 11 May 2001) have given EMI an extra boost. A June 2001 announcement by HM Treasury proposes doubling the current £15 million asset limit. Briefly:

  • EMI options are relatively simple to grant.
  • EMI options should fit in well with a company's incentive requirements.
  • Any number of employees can participate at any time but subject to the total value (at grant) of shares under EMI options not exceeding £3 million with effect from 11 May 2001.
  • Each EMI option holder may only hold options over shares of a value (at grant) of up to £100,000.
  • Companies with gross assets exceeding £15 million, or which carry on certain businesses, cannot grant EMI options. The £15 million limit is likely to be increased to £30 million next year.
  • Some companies cannot grant EMI options because of their ownership arrangements or group structure.
  • There are very significant potential tax advantages for option holders.
  • EMI options solve the employer's national insurance contributions (NICs) problem.

What Is An EMI Option?

An EMI option operates as follows (with reference to typical documentation):

  • The company checks it can grant EMI options.
  • The market value of the shares under option (unless they are quoted on a recognised stock exchange) is agreed with the Inland Revenue (prescribed valuation request form).
  • The board selects the key employees and grants options to them to acquire shares in the company within a defined option period (option agreement and board minutes).
  • The grant of each EMI option is notified to the Inland Revenue within 92 days (prescribed form of notice – 30 days for options granted before 11 May 2001).
  • An annual return is submitted to the Inland Revenue (prescribed form).
  • The option holder either exercises the options in whole or in part (notice of exercise of option) and acquires shares or allows the option to lapse.
  • Any shares received belong to the employee subject to any restrictions or conditions that may be attached to those shares.

Only an option granted after 28 July 2000 (the date of passing the Finance Act 2000) can qualify as an EMI option.

Using EMI Options

An EMI option is an equity incentive for employees: it provides an option holder with an opportunity to acquire shares. There will normally be a cost to the option holder (the exercise price) but an option will not usually be exercised unless it is "in the money". EMI arrangements can operate on a selective basis but could (within the £3 million limit) be made available to all employees. Conditions may be attached to the exercise of EMI options (e.g. options might only be exercisable on achieving a target event, such as an Initial Public Offering if the company is unlisted, or according to a vesting schedule). Discounted options can be granted (i.e. the exercise price can be less than market value of the shares subject to the option at the date of grant).

The key questions are:

  • Does the equity incentive the company wants to provide fit within the EMI framework?
  • Are the qualifying conditions a problem?

The EMI Framework

  • An option must be granted for commercial reasons in order to recruit or retain a key employee in a company, and not as part of a tax avoidance scheme.
  • Any number of employees may hold EMI options over shares in the relevant company at the same time.
  • The total value (at grant) of shares under EMI options must not exceed £3 million.
  • The market value of shares under option to any employee calculated at the time an option is granted must not exceed £100,000.
  • The company whose shares are the subject of the option must be a qualifying company (see below).
  • The individual to whom the option is granted must be an eligible employee (see below) in relation to that company (and the option must be granted by reason of employment with that company or another group company).
  • There must be an option agreement in writing which meets certain requirements.
  • The option must satisfy other requirements (e.g. as to the type of shares that may be acquired).
  • If the exercise price is set at market value at the time the EMI option is granted, then the exercise of an EMI option within ten years of the date of grant is completely tax free for the participant (with no NICs payable by the employer).
  • The shares acquired on the exercise of an EMI option will benefit from capital gains tax (CGT) taper relief, calculated as starting from the date of grant of the option.
  • The tax advantages will, in broad terms, cease to be available if there is a disqualifying event (see next page).

Are The Qualifying Conditions A Problem?

Qualifying Company

A company can only grant EMI options if it meets certain qualifying conditions at the time the options are granted, including:

  • Gross assets must not exceed £15 million.
  • The company must satisfy an independence test (i.e. it must not be a subsidiary and must not otherwise be under the control of any other company).
  • Any subsidiaries must be at least 75% subsidiaries.
  • The company (the group) must carry on one or more qualifying trades.
  • The trading activities must be carried on wholly or mainly in the UK (at least one company in the group must be carrying on a trade wholly or mainly in the UK).

Many trades will qualify but some are excluded. The exclusions are set out in the Appendix to this briefing paper on page 6. These exclusions are based on the rules of the enterprise investment scheme. The receipt of, for example, royalties or licence fees can be a problem. However, certain royalties or licence fees attributable to intangible assets created by the company (or in the group) do not prejudice qualifying trade status.

Eligible Employees

The employee must be employed by the company (or a group company). An employee's commitment of working time must amount to at least 25 hours a week, or if less, 75% of his or her working time.

For this purpose working time consists of all time spent on work:

  • the income from which is chargeable to tax under Case I of Schedule E; and
  • the profits from which are chargeable to tax under Case I or II of Schedule D.

It includes time which would have been spent on this work except for injury, ill-health, disability, pregnancy, childbirth, parental leave, reasonable holiday entitlement or not being required to work during a period of notice of termination of employment. It also includes work which would have been chargeable under any of the cases above had the employee been resident in the UK.

The Option Agreement

The grantor of the option and the employee must enter into a written agreement which states:

  • The date of grant of the option.
  • That it is granted under the provisions of Schedule 14 of the Finance Act 2000.
  • The number, or maximum number, of shares that may be acquired.
  • The price (if any) payable on exercise (or the method by which it is to be determined).
  • When and how the option is to be exercised.
  • Any conditions, such as performance conditions, affecting the terms or extent of the employee's entitlement.
  • Details of any restrictions attached to the shares.
  • Details of conditions attached to the shares if, when acquired, they will be subject to a "risk of forfeiture".
  • That the person to whom it is granted is prohibited from transferring any of his or her rights under it and, if they permit exercise after that person's death, do not permit such exercise more than one year after death.

Other Qualifying Conditions

The shares under option have to meet certain qualifying conditions. They must be ordinary shares, fully paid up, and non-redeemable.

Companies are able to award EMI options over restricted and conditional shares. The market value of shares subject to restrictions or risk of forfeiture is determined as if there were no such restrictions or risk.

The option must be capable of exercise within ten years from the date of grant.

EMI options cannot be granted to any employee who controls 30% or more of the ordinary share capital of the company.

Disqualifying Events

There is also a requirement to avoid disqualifying events during the life of each EMI option.

The disqualifying events to a great extent mirror the qualifying conditions already described but do cover other matters. There will be a disqualifying event if the relevant company:

  • Ceases to meet the independence test.
  • Ceases to satisfy the trading activities requirement.
  • Makes certain alterations to its share capital.
  • Converts option shares into shares of a different class unless this is a permitted conversion (as defined).

There are also disqualifying events, if the employee:

  • Ceases to be an employee of the company (or a group company).
  • Ceases to satisfy the requirement as to commitment of working time.
  • Receives the grant of an Inland Revenue approved company share option plan ("CSOP") option (by reason of his or her employment with the relevant company or group), if, immediately after it is granted, the employee holds unexercised EMI options and CSOP options in respect of shares with a total value of more than £100,000.

There are other disqualifying events. However, achieving gross assets of more than £15 million is not a disqualifying event.

If the EMI framework looks right, and the company is confident the qualifying conditions are not a problem it must then decide whether or not the tax advantages make EMI options worthwhile.

Are The Tax Advantages Worthwhile?

An EMI option provides a method of avoiding an income tax charge of up to 40% that would usually apply to an employee on the exercise of an option.

The tax free exercise can take place any time, no later than the tenth anniversary of the date of grant, providing the option continues to qualify as an EMI option.

A participant who acquires shares tax free may have a CGT liability, but this will only arise when the shares are sold.

The first £7,500 (2001/2002) of all chargeable gains in a tax year are exempt from CGT. Taper relief may apply to reduce the effective tax rate depending on the shareholder's circumstances and the number of complete years the shares are held (in addition to the period for which the EMI option was held). Maximum taper relief for business assets achieves an effective CGT rate of only 10% for higher rate tax payers. Maximum taper relief is currently available after four years. This period could fall to only two years with effect from next year if a proposal announced by HM Treasury in June 2001 is implemented.

No employee's NICs will be payable on either the grant or exercise of EMI options, subject to the following comment on discounted options.

If an EMI option is granted at a discount, then the discount is taxed as normal (i.e. usually subject to income tax and, if applicable, NICs on exercise).

As well as tax advantages to employees, there is a very important tax advantage for employers. In the case of an unapproved option, the employing company will usually face an employer's NICs charge when an option is exercised. This charge is currently 11.9% (without limit) on the difference between the exercise price and the market value at the time of exercise of the shares acquired. This liability is unquantifiable at the outset and is a major concern for many companies. In contrast, under the EMI provisions there is an exemption from NICs whenever an EMI option is exercised (except as regards any discount).

If a disqualifying event occurs, then any increase in market value from immediately before the disqualifying event will, in broad terms, be subject to income tax on the exercise of the option (in addition to any tax already payable on any discount given at the time of grant). This income tax charge can be avoided if the option is exercised within 40 days of the disqualifying event (if this is permitted under the terms of the option).

As to CGT, if a disqualifying event occurs, shares acquired by the exercise of the option are qualifying shares (for the purpose of the enhanced taper relief) only if the option is exercised within 40 days of that event.

The Rival Company Share Option Plan

There is a long established alternative method of granting options to key employees. This is the Inland Revenue approved company share option plan (CSOP). Points to note about a CSOP are:

  • Options can only be granted under a CSOP after Inland Revenue approval of the plan has been obtained.
  • Options can only be granted at an exercise price at or above the market value of the shares under option as at the date of grant.
  • The income tax advantages to participants are similar to those under the EMI provisions but a tax free exercise can only be made after an option has been held for three years.
  • Each participant may only hold options with a value up to £30,000 (at grant).
  • Companies of all sizes and whatever their business can establish CSOPs.
  • Any number of employees can participate.
  • A CSOP also solves the employers' NICs problem.

Although a CSOP option is less advantageous in some important respects than an EMI option, a CSOP option is free from the complexities of the EMI arrangement, with its array of potential disqualifying events. A separate briefing paper is available from FFW upon request which provides more information on CSOPs.

How FFW Can Help

We can advise on whether or not an EMI arrangement is possible for your company. We can help you decide whether or not it is worthwhile granting EMI options or whether another form of equity incentive is better suited. We can prepare all the option documentation and deal with the notification procedure. We can also assist with other aspects of granting EMI options.

Who Are We?

FFW’s employee benefits and share schemes group has substantial experience in all aspects of employee benefits, including equity incentives. Graeme Nuttall, head of the team, is a member of the HM Treasury advisory group which helps the Inland Revenue introduce new share schemes including EMI. Through membership of the Global reward plan group we implement international share schemes.


Excluded Activities For EMI Purposes

The following activities are excluded activities. A company which includes these as a substantial part of its trade (substantial can be taken as comprising 20% or more of the trade) would be a non-qualifying company:

  • dealing in land, in commodities or futures, or in shares, securities or other financial instruments
  • dealing in goods otherwise than in the course of an ordinary trade of wholesale or retail distribution
  • banking, insurance, money lending, debt factoring, hire-purchase financing or other financial activities
  • (most) leasing activities or receiving royalties or licence fees provided that if, in broad terms, the royalty/licence fee relates to a relevant intangible asset created by the trading company or the parent company or a qualifying subsidiary of the company; the company will not be disqualified simply by reason of receiving such income
  • providing legal or accountancy services
  • property development
  • farming or market gardening
  • holding, managing or occupying woodlands, any other forestry activities or timber production
  • operating or managing hotels or comparable establishments, or managing property used as a hotel or comparable establishment
  • operating or managing nursing homes or residential care homes, or managing property used as a nursing home or residential care home.

In Addition To The Main Excluded Activities:

  • R&D counts as carrying on a qualifying trade if a qualifying trade will derive from it, but preparing to carry on R&D does not count as preparing to carry on a qualifying trade
  • the provision of facilities for another business which carries on a non-qualifying trade can be an excluded activity.

This document is intended as a general guide on complex subjects. It is not intended as a comprehensive review. It should not be relied upon as a substitute for advice in a particular circumstance.

© Copyright Field Fisher Waterhouse 2001.

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